Split Incentive Series: Tackling Financial Barriers (Part III of V)

Written by: Daniel Handal

Tackling financial barriers in the split-incentive is the topic of our third blog in the series on the challenges of implementing energy efficiency in the commercial real estate (CRE) market. Previously we discussed overcoming the market structure; in this blog, we continue the discussion by addressing the financial barriers to the adoption of energy efficiency.

The Financial Barriers

Ultimately, modernizing buildings is good business. However, financial barriers prevent the investment in energy efficiency due to actual or perceived “first-cost” hurdles or externalities associated with assessing or implementing the projects. To overcome the barrier, the business case for energy efficiency should be framed as an aspect of a customer’s core business operation. For example, for office buildings, renting the space is their core business, so they may need to be convinced that tenants will pay more for higher efficiency spaces.

Using a Business Case to overcome the “first-cost” Hurdle

One financial barrier found across energy efficiency projects is the “first-cost” hurdle, an investment horizon in which the high “first-cost” of the energy efficiency project & payback of the improvement may be longer than the intended hold time of the asset. Waypoint found a solution in that working with property management first significantly helped in identifying the right decision makers (building ownership and/or tenants) and in developing metrics from leasing and utility data that would appeal to the party who is incurring the majority of the cost. Property managers requested details on annual savings ($), payback (years) and ROI (%) so that they could help decision makers quantify the costs of delaying energy efficiency projects.

Building owners have several good reasons to fund investments in capital upgrades (a category under which energy efficiency often projects fall) completely and split costs savings with tenants (depending on lease structures). Capital upgrades can result in the following benefits:

Increase asset value

Increase asset marketability - position cost savings as an added “service” to tenants

Improve relations with tenants - may aid future lease negotiations

Using Financials Tools to execute the Business Case

Building owners can work to fund energy efficiency projects by leveraging a variety of financial tools, some of which are highlighted below.

Energy-Aligned (Green) Leases:Green leases align priorities between tenants and owners to minimize the split-incentive. They can range in complexity from basic sustainability clauses (e.g. recycling) to cost pass-through clauses. For example, PlaNYC, an effort from the New York City Major’s office, developed a unique energy-aligned leasing language option to solve the split incentive issue for typical modified gross commercial leases and generally for multi-tenant net office leases; base owners’ cost recovery on predicted savings but limit owners’ capital expense pass through to 80% of such predicted savings in any given year. Leasing language and additional explanations on the leases are available at the Green Lease Library website.

Anchor Tenant Financing: This performance contracting innovation enables a long-term tenant (an “anchor”) who occupies all or a large part of a building to benefit from energy retrofits made with the owner’s cooperation. The owner works with an energy service company to complete the retrofit and passes the cost to the tenant by way of the lease. The tenant then uses the guaranteed energy savings to offset the higher lease cost and pockets the excess savings.

Property-Assessed Clean Energy (PACE) Bonds:PACE programs allow investments in energy-efficiency retrofits to be paid back through property taxes. In California, one way to tap into these programs is through CaliforniaFIRST.

On-Bill Financing: Another utility funding option is On-Bill Financing, in which building owners and tenants receive a loan to fund qualified energy efficiency projects for as little as zero interest and no fees while also receiving financial incentives for installing qualifying energy efficient equipment. The loan gets repaid in monthly installments which are added as a line item on the utility bill.

While it’s important to determine how a project will be funded, it’s also critical to overcome the informational and physical building barriers to identify energy efficiency projects in the first place. Stay tuned for our next blog on overcoming another split-incentive barrier in regards to educating stakeholders and understanding building intricacies.